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Though originally posted as a comment here, I don't see an answer. So please allow me to resurrect and broaden this question, to all investment-grade bonds: in other words, 'BBB- or higher by Standard & Poor's or Baa3 or higher by Moody's.'.

Why should the prices of these
[highly rated bonds from pension funds, mutual funds, etc. because of their investment mandates]
bonds drop? Isn't there always a demand for ... [investment-grade] bonds with more than 10% coupon?

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With bonds, it's more about yield to maturity (YTM) than about supply and demand. Or better said, YTM is what is demanded, not so much the credit rating of the issuer. YTM is a function of the price paid for the bond and the interest paid over the life of the bond. The interest is fixed (or at least pre-determined), so an existing bond's YTM can only be adjusted in the marketplace by adjusting the purchase price.

When new bonds are issued with higher rates, investors will demand that the bonds they buy have a competitive YTM. So existing bonds will have to drop their price in order to boost their YTM to match the other bonds on the market. The same effect happens when bond rates fall, just in the opposite direction.

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Why should the prices of these [highly rated bonds from pension funds, mutual funds, etc. because of their investment mandates] bonds drop? Isn't there always a demand for ... [investment-grade] bonds with more than 10% coupon?

Beware of 2 assumptions in the questions:

  1. Companies can have ratings changed and thus what may start out as an investment-grade bond may end up as a junk bond or did you believe that bonds couldn't have their grades altered?

  2. What interest rate environment is there here? There may be a perception that rates may rise in the next few years so that 10% could look small as back in the early 1980s in the US short-term rates were over 20% once in which case a 10% coupon would look rather low in comparison.

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